How luck can sabotage fund performance

Investors seeking outsized performance may need even more courage and patience than they thought

How luck can sabotage fund performance

Value investors are no strangers to the importance of discipline. The strategy, which relies on time rather than timing, requires them to stay steadfast even as choppy markets eat away at their daily, weekly, and monthly returns. Just stick to it, they think, and they’ll eventually beat the market.

But an experiment by University of Chicago finance professor and Nobel laureate Eugene Fama and Dartmouth professor Ken French suggests it’s not that simple, according to the Wall Street Journal. In fact, holding on for more than 10 years improves the odds of outperformance — but doesn’t guarantee it. And for shorter periods, the chances of falling short increase simply because of bad timing.

Fama and French wanted to know what would happen if an investment strategy’s return in each of the next 120 months were equal to what it was in 120 randomly selected months from the past five decades. Running the simulation 10,000 times for different strategies, they determined how often a strategy lagged behind its benchmark.

“Even with their generous assumption, they found that … there was a significant probability the strategy would lag behind its benchmark over a 10-year period,” the Journal said. Looking at value investing, for example, Fama and French calculated that the strategy had a 9% probability of lagging over any given 10-year period. That falls in line with how the average value stock hasn’t done as well as the average growth stock over the past decade.

“Statistical noise—luck, in other words—is always the first possibility to consider, especially when a compelling model says the expected premium is positive,” French told the Journal. He added that other factors may explain the disappointing showing from value stocks, though bad luck is a likely possibility based on the tests he and French conducted.

Testing strategies that favour small-caps over large-cap stocks led to similar results. Despite having an impressive historical record over the past half-century, the two found a 24% probability of small-caps falling behind large-caps over any 10-year window. And comparing the performance of equities with that of riskless T-bills, they found a 16% chance of the former doing worse than the latter; even pushing the time horizon to 20 years led to a “nontrivial” 8% chance of equity underperformance, they said.

The upshot, according to the researchers, is that one “cannot draw strong inferences” about a fund’s potential from three, five, or even 10 years of record returns. And those who decide to put money behind a strategy must be prepared to give it at least 10 years to bear fruit, even if it has significant periods of market-lagging performance.